Bank of England, which let existing standing facilities take strain of increased liquidity demand (photo: Shaun Curry/AFP)
Subprime fallout
The IMF has already held discussions with central bankers and market participants in Europe, Asia, and North America. The IMF believes that an examination of the different approaches followed by the European Central Bank (ECB), the U.S. Federal Reserve (Fed), and the Bank of England (BoE) holds lessons that could be useful to all central bankers.
Big challenge for central banks
The financial turmoil that broke out in August 2007 presented major challenges to a number of advanced-country central banks, in particular the ECB, the Fed, and the BoE.
Central banks in normal times aim to provide sufficient liquidity to the financial markets at or around the policy interest rate (the monetary policy interest rates set by the ECB's Governing Council, the Fed's Federal Open Market Committee, and the BoE's Monetary Policy Committee), with the expectation that
• their counterparties—the commercial banks and securities firms that deal directly with the central bank in Open Market Operations (OMO)—will distribute liquidity among market participants as needed, and
• there is a reasonably stable relationship between the very short-term interbank rate that the central bank targets, on the one hand, and longer-term money market rates that influence demand in the economy, on the other.
The subprime crisis, which began in the United States, disrupted market functioning, with the result that previously stable relationships in the wholesale money markets in both the United States and Europe broke down; the yield curve became steeper and more volatile; and the gap between secured and unsecured rates widened. For the Fed, in particular, the economic impact of the subprime crisis also required a reappraisal of its monetary policy stance toward a more accommodative posture, to offset economic weakening and tighter credit conditions.
Need for liquidity
Central banks typically make available a standing credit facility—which banks can use at their discretion—for overnight borrowing, but the interest rate is significantly higher than the policy rate to discourage banks from making excessive use of this facility.
In the days following the onset of the crisis, there was an increase in demand for liquidity, and both the ECB and the Fed provided additional OMO funding to avoid a spike in short-term rates. The BoE preferred to let its existing standing credit facility take the strain, although this involved higher overnight interest rates. Chart 1 shows how market rates differed against a background of different operational frameworks and central bank actions.
As time progressed, it became evident that commercial banks did not want larger central bank balances: rather they wanted more liquid assets (very short-term or repo loans) and longer-term liabilities (because term funding in the market disappeared). The yield curve became steeper and more volatile, making it harder to determine the impact of the central banks' policy rate on the economy (see Chart 2).
IMF examination
In response to a request from the IMF's policy guidance body, the International Monetary and Financial Committee, the Fund has set up a working group to analyze how the central banks reacted to the crisis. The working group, organized by the IMF's Monetary and Capital Markets Department, is examining developments in the context of each country's financial market structure, with a view to drawing conclusions that would benefit the entire membership.
Differences in how each central bank acted are more prominent in three areas: the number of the central bank's direct counterparties, the provision of more long-term lending, and the acceptance of a broader array of collateral.
Central banks' operational response
The Fed normally operates directly with around 20 primary dealers, who distribute the liquidity provided by the Fed around the market, while some 7,500 banks have access to the discount window. The ECB normally operates with around 300 banks, though 1,700 are able to participate in its regular operations and another 700 have access to standing facilities. The BoE operates in a smaller market, with around 40 normal counterparties in its OMO, and a further 20 or so that can access standing facilities. When money market relationships broke down, the ability to operate directly with a wide group of counterparties proved important.
In support of market liquidity, the central banks involved did not provide liquid assets directly, but effectively freed up collateral for interbank transactions by accepting less liquid collateral themselves. For the ECB, which already had a wide definition of eligible collateral, this was automatic: banks increased the amount of nontradable collateral pledged to the ECB.
The Fed and the BoE had to adjust their instruments to accept a broader range of collateral at market rates: the Fed lowered the discount rate spread over its target rate in September, and in December introduced a Term Auction Facility (TAF) to provide $40 billion in one-month funds. (A further $14 billion were made available to European banks via a swap facility arranged with the ECB and the Swiss National Bank.) The BoE accepted a wider range of collateral in its existing three-month funding operation.
Massive liquidity provision
Longer-term lending has been provided in different ways. The ECB and BoE had existing OMO at maturities of three months and over, conducted at market rates. The ECB doubled the amount of its three-month maturity OMO from 150 billion euros in July 2007 to around 300 billion euros in January 2008, while its short-term (seven-day maturity) OMO lending was roughly halved from around 300 billion euros to compensate.
The BoE faced a more difficult task: the massive liquidity provision to Northern Rock—a mortgage lender that was deemed solvent but illiquid as it proved to be over-reliant on wholesale market funding—meant the BoE had to reduce its OMO lending to compensate.
Lending through seven-day maturity OMO dropped from over 30 billion pounds in the first half of 2007 to under 5 billion pounds in early 2008. An increase of 6 billion pounds in commercial banks' contractual reserve holdings was needed to enable the increase in three-month OMO lending to the market in January. The Fed also had to adjust its asset structure—by redeeming at maturity some of its holdings of U.S. government securities, it withdrew liquidity to create room to set up the TAF (a one-month OMO) with an initial volume of $40 billion.
Discount window stigma
The Fed and BoE also had to address collateral issues (the ECB's broader range of collateral is eligible for both OMO and standing facilities). In the United States, lending through the discount window (the Fed's Standing Facility) has a much broader definition of eligible collateral than for OMO, and a much larger number of institutions have direct access, but the stigma associated with it restricted its effectiveness. The TAF bridged the gap by providing OMO funding using discount window collateral and counterparties (93 institutions bid in the first TAF, and 73 in the second).
In the United Kingdom, offers of one-month OMO funding at a spread above the standing facility rate (in September and October) met no demand; but a broadening of the eligible collateral pool for the three-month OMO offered in January did elicit some response.
Further investigation
The nature of the market pressures and the different approaches taken by the three major central banks raise a number of issues that the group will investigate further.
• The ability to operate directly with a wide range of counterparties is helpful in times of stress.
• Reserve averaging provides useful flexibility in response to market shocks, but banks are reluctant to hold a high level of reserves if they are not remunerated.
• The acceptance of a broad pool of collateral can facilitate central bank lending during times of stress. However, it is important that collateral pricing policy be reviewed periodically to ensure that it provides banks proper incentives to hold and use more liquid and better quality collateral, thereby limiting the risk to the central bank and promoting better liquidity management.
• A flexible asset structure is important in allowing a central bank to manage liquidity conditions.
